Viewpoint: Clear Up Capital Regs, Free Up Capital Access

Banks have formidable challenges ahead of them. To meet those challenges, a better economy will help, but so will access to new sources of capital.

The skyrocketing number of formal and informal enforcement actions brought by federal banking regulators, and the Treasury Department's principles for reforming the bank regulatory capital framework provide a sobering glimpse into the quantitative and qualitative augmentations of bank capital requirements that are likely to come.

At the same time, regulatory hurdles have been erected for some capital investors. The most concrete examples of new policies with regard to private capital are the Federal Reserve Board's September 2008 statement on private-equity investments in banks and the FDIC's August 2009 statement of policy on qualifications for failed-bank acquisitions.

Some policies, however, have been developed on a transaction-by-transaction basis, leaving uniformity and clarity to suffer. The FDIC is reviewing its policy to determine whether the first six months of its life suggest the need for change to some, all or none of it.

Among the investors that have been involved in recapitalizing failed, failing or live banks in the past three years, private-equity funds and hedge funds have been singled out for special treatment.

Though that treatment may be triggered as much by the structure of a transaction as who the investors are, the FDIC has to date declined to define the private investors that are subject to its policy statement. The result is that the rules of engagement, save one, are uncertain at a very important time for the attraction of outside bank capital. The one rule that seems clear is that certain private investors must accept a regulatory "surcharge" in return for regulatory approval.

The FDIC's policy statement represents the critical tension in this complicated relationship between private capital investors and federal bank regulators. Wall Street, the capital markets, capital intermediaries and sources of capital are all changing.

Through all this change, the regulators understandably must decipher how the new capital markets of 2010 relate to bank investment laws and regulations written as many as 50 years ago.

Similarly, private-equity and hedge fund investors are trying to accommodate the rules, which, even when they are clear, are actually applied differently by each of the four federal bank regulators in some cases.

The parties have seemed to move toward each other as familiarity has grown. Some private-equity and hedge fund investors — many a cross section of Main Street America with investors that include pension funds, unions, charities, universities and governmental entities — have moved in the direction of diluting their presence by participating in blind pools with diverse equity participants led by talented bank management teams.

When the goalposts are continually moving, however, it becomes more difficult for banks to attract this capital. Indeed, the rules have recently been informally expanded to require greater information from relatively de minimis investors, "request" that investors not expressly covered by the terms of the FDIC's statement of policy conform to it and mandate that certain foreign private-equity and hedge fund investors agree to become U.S. taxpayers.

Having drafted the control rules at two different federal banking agencies and having represented private-equity and hedge fund investors and large and small banks seeking capital from these investors, it would appear to this observer that the current tension flows from three fundamental points. First, private-equity and hedge fund investors generally are not willing to become bank holding companies or acquire "control" of a bank or bank holding company. That naturally limits the interests of private investors to 24.9% voting and, in certain circumstances, 33% of the equity of the target institution, suggesting the need for multiple investors.

Second, bank regulators seem to be uncomfortable with the idea that multiple private-equity and hedge fund investors could acquire a failing or failed bank and not control it, albeit that such a result is clearly provided for under the law.

This appears to be related to a third concern — that private-equity and hedge fund investors of a bank would cause its risk profile to increase at the expense of the FDIC.

None of these hypotheses are borne out by any empirical evidence developed to date, as was suggested by one of the directors of the FDIC when it adopted the policy statement by a split vote. There is no record of regulatory actions that would support the proposition that banks have failed because of the influence of private-equity and hedge fund investors, and no enforcement cases brought by the federal bank regulators against private-equity and hedge fund investors for violation of their passivity or concerted action commitments.

The same FDIC director also questioned the reason for concern over the alleged opaqueness of private-equity and hedge fund investment vehicles given the enormous amount of information required by the federal banking agencies when any acquisition of a bank or thrift occurs.

Time is of the essence if banks are to enjoy the relief that new capital can bring. Conditions will change and so will the availability of capital. Even if only on a trial basis, given the absence of any record of abuse, it makes sense to trust the laws that are on the books, allow multiple transactions by private-equity and hedge fund investors pursuant to those rules and vigorously enforce them, even if it means special examinations of investor compliance with them.

At the same time, to build more certainty into the investment process, which will unquestionably bring more capital, the regulators should clarify, standardize and modernize: bank control and acquisition rules to better reflect current issues, concerns and channels of capital; the definitions of the types of securities that may create "control" issues; and the presumptions that determine when investors are and are not deemed to be acting in concert for purposes of control of a bank.

Finally, it may be time to consider whether there is room for a new category of investor between one that is controlling and one that is passive.